Articles Posted inReal Estate Partnerships

Investors in California real estate hope for returns on their investments, but they must also understand the inevitable risks. A real estate investment, whether it involves participating in a real estate syndicate, buying shares in a real estate investment trust or buying land for development, is a business venture. All business ventures involve risk, starting with the loss of the investment principal and continuing to the limits of the imagination. Investors should carefully consider their potential liabilities and plan a business entity accordingly. Proceeding without any formal legal structure creates a sole proprietorship or general partnership, which offers no protection from liability. California law allows real estate investors to form various business entities that can shield them from liability for business obligations, including a limited liability company (LLC).

Investing in California real estate is generally considered a business activity, meaning that it is undertaken for the primary purpose of making a profit, as opposed to charity or recreation. Business activities can have important effects on a person’s life and finances, including taxes and other potential liabilities.

When an individual invests in an ongoing venture like a real estate syndicate or a real estate investment trust (REIT), they are buying equity in an existing business. When one or more individuals engage in their own investment activity, such as by buying a house with the intention of flipping it, they have effectively started their own business.

In a recent unpublished California appellate decision, the plaintiff appealed after a bench trial was conducted on his complaint for breach of contract and breach of fiduciary duty. The case arose when one of the defendants, who’d worked as a real estate developer in Illinois for 21 years before moving to San Diego, needed seed money for a potential development. He contacted his childhood friend to see whether he’d be interested in creating a partnership to invest money to follow the opportunity.

The childhood friend agreed and formed Gimbel Corporation with another friend. Meanwhile, the defendant formed Kriozere Corporation, in which he was the sole shareholder. The two corporations formed a general partnership. Gimbel invested $250,000 in a development in downtown San Diego, and both partners enjoyed profits from this first project.

In 1993, the initial partnership agreement was changed to reallocate profits between the partners. Gimbel invested in some properties with Kriozere under the second agreement. In 2006, the partners restructured their partnership so that Gimbel was a limited partner, while Kriozere was a general partner. The childhood friend’s other friend replaced the childhood friend as director of Gimbel.

In a recent California appellate decision titled Ito v. Ito, the appellate court considered how to value two brothers’ respective interests in real estate they’d bought and sold. One of the brothers, a programmer, had gone into business with the other, a real estate investor, and then they fell out. The programmer sued the investor to wind things up. Ultimately, the real-estate investor appealed.

The main issues in the lawsuit were how to value each brother’s interest in real estate they’d bought and sold and how to treat their interests in a corporation they’d formed to make arrangements. The programmer testified that when they formed the corporation, he was making more than $300,000 a year as an independent contractor. His brother had no money, and the programmer agreed to do his business through a corporation and give his brother a 50% share of the business to take advantage of the brother’s tax losses. The brother got a salary under an employment contract with the corporation, but according to the programmer, he didn’t do anything for the corporation. In 2002, the brother forfeited his share of the business.

At trial, the court labeled the corporation an illegal scheme by the programmer to avoid paying income taxes and decided the brother had no interest from the beginning. The brothers had jointly bought about 39 properties and continued to own six of them through partnerships and limited liability companies at the time of trial. The investor argued that their interests should be determined by their capital accounts in the property, with the amount of the accounts fluctuating based on their contributions. He argued that the programmer’s capital accounts for the properties were zero because whatever he’d put in, he got back in the form of payments he’d received from the investor.

Sometimes investors in California are interested in having the flexibility of a partnership structure but are worried about personal liability. In a limited partnership, there are one or more general partners and one or more limited partners. There always needs to be at least one general partner, and the general partner or general partners will have unlimited liability for the partnership’s debts and liabilities. Under California Corporations Code § 15611, the limited partners contribute capital but don’t get to manage or have other responsibilities and aren’t held liable for partnership obligations that go over their capital contributions. Often, however, an Limited Liability Corporation (LLC) is considered a more favorable vehicle for real estate than a limited partnership in California. For example, all of the owners of an LLC can manage it.

To form a limited partnership in California, investors file a certificate of limited partnership. Limited partners do not need to disclose their names or legal information. There is no legal requirement that a partnership agreement be in writing, but it is important to have one. The agreement will set forth why the partnership is being created, how business is going to be conducted, the rights and liabilities of each partner, and other contingencies. Negotiating and creating a written agreement about how a limited real estate partnership will be conducted can eliminate litigation down the road.

In most cases, a limited partnership is a good way for passive investors in real estate to become involved. A limited partner gets to invest in real estate and share in profits when the project is successful, but they aren’t held responsible for liability when it exceeds their initial capital contribution. The general partners are liable beyond this amount and are considered jointly and severally liable to third parties when a lawsuit arises from their actions on behalf of or in the course of the partnership.